(Bloomberg) -- Bond prices are rallying on expectations the Federal Reserve will soon start cutting interest rates at a recession-fighting pace, creating a risk that traders are again underestimating the strength of the US economy.
The gains extended on Tuesday, slashing the yield on two-year Treasuries to around 3.85% from more than 5% in late April. The advance over the last four months marked the longest winning streak since 2021.
The move has been driven by anticipation that the central bank will reduce its benchmark rate by more than two full percentage points over the next 12 months, which would be the steepest drop outside of an economic downturn since the 1980s.
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For bond bulls, that’s created a risk that the labor market — which cooled sharply in July — will show resilience, allowing the Fed to move at a more moderate pace. The first major test comes on Friday, when the government releases August payroll data that economists expect to show a rebound in job growth and a drop in the unemployment rate.
“If you missed the big rally, it’s going to be a little dangerous to chase it now,” said Ed Al-Hussainy, a rates strategist at Columbia Threadneedle Investments. “We are playing with the probability of the job market stabilizing here or deteriorating fast. That’s the debate for the rest of the year.”
While still inclined to hold bullish bond bets, he said “that’s not a straight forward trade.”
Treasuries have delivered a return of over 6% since late April as investors anticipate that cooling inflation will allow policymakers to start pulling their main policy rate back from a more than two-decade high.
The rally echoes the one that broke out late last year, which reversed after it became clear that the Fed was not going to move as quickly or as aggressively as anticipated.
But the Labor Department’s last monthly jobs report showed that the unemployment rate rose to a nearly three-year high and payrolls expanded at one of the weakest paces since the pandemic, briefly stoking fears that the Fed had waited too long to start easing policy and the economy was inching toward a recession.
Those worries have since ebbed. Economists at Goldman Sachs Group Inc., for example, have cut the probability of a recession in the next year to 20%.
Yet at the recent Jackson Hole symposium, Fed Chair Jerome Powell signaled that the priority has shifted from inflation fighting to protecting jobs, saying any further cooling in the labor market would be “unwelcome.” He refrained from using the word “gradual” to describe the pace of its coming moves, which some investors saw as opening the door for fast ones.
Traders are now anticipating that the Fed will cut its rate by a full percentage point by the end of the year, implying an unusually large half-point reduction at one of the three meetings left in 2024.
To be clear, that doesn’t mean that investors are betting a recession is inevitable. In fact, markets are anticipating the US will likely avert one, leaving the S&P 500 Index holding not far from a record high. The Fed has raised rates so high that it would need to drop them considerably just to get closer to the rate that’s seen as neutral to economic growth — which is currently estimated to be around 3%. The Fed’s benchmark is in a range of 5.25% to 5.5% now.
With policymakers still mindful of the recent inflation surge, though, the question is whether the labor market is weak enough to warrant those easing expectations.
The signals have been mixed. While the Conference Board’s recent consumer survey showed jobs are less “plenty,” the number of initial weekly jobless claims has remained stable in the past few months. Economists expect the Sept. 6 payroll report to show that job growth quickened to 165,000 from 114,000 and the unemployment rate dipped to 4.2% from 4.3%.
As a result, some investors and strategists are inclined to fade the bond rally. Deutsche Bank’s strategists recommended their clients selling 10-year Treasuries on Aug. 26, targeting a move higher in the yield to 4.1%. It was around 3.83% Tuesday.
What Bloomberg Strategists Say:
“It is difficult to see, from a dispassionate look at the data, how more than 200 bps of rate cuts could be vindicated given that an NBER recession in the next 3-4 months looks less likely than not. The economy moves relatively slowly; only a rapid market decline, similar to what we saw recently, which triggered a recession-inducing feedback loop would justify the the steep cuts anticipated.”
—Simon White, MLIV strategist. Read more.
In addition to the stable jobless claims, the strategists noted the seasonal tendency for bond yields to rise in September as corporate issuance typically ramps up after the summer lull, adding supply pressure to the market.
Over the past decade, September marked the worst months for bond investors. The 10-year Treasury yield rose that month in eight of past 10 years, climbing an average of 18 basis points.
“We think the market is pricing in too much, too soon,” said Leslie Falconio, head of taxable fixed-income strategy at UBS Global Wealth Management. “We still view the soft landing as the likely outcome. We would add interest-rate risks here, but wait for better levels.”
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